The Beauty of Compounding & Importance of Rate of Interest

This is said so often, ever so often. We've learnt it in high school - remember all those simple interest and compound interest rate formulas? It's amazing - the simplicity of the math. What does compounding mean? Why is it used so often in conjunction with wealth creation?

Well, let's dive right into it. The amount that you are going to invest in your first year - say on 1st of January, that's the principal amount. Let's say you just received your year end bonus of 1 lakh; and you decide to place this entire sum in a Fixed Deposit (FD) in your regular bank; which gives you 6.5% interest per annum.

Let's see what happens to your money. Your money (1 lakh @ 6.5% per year) grows to 1 lakh and 6.5k in exactly one year. But the magic starts in the second year. Your new starting point is now 1,06,500 which @ 6.5% - becomes 1,13,423 by January 1, 2021 - i.e. after 2 years. In the table below, you can see how the money grows year on year (Y-O-Y).

But the beauty is understanding the importance of the rate of interest.

Looking at the figure on the right; you can see the different amounts after 7 years - @ 6.5%, 7% & 7.5%. There is a significant increase of 10k to your savings by getting 7.5% vs 6.5%. Imagine having put 10 lakhs as your starting principal - then the difference would be 10 times, i.e. - an increment of 1 lakh to your savings just by choosing a bank that gives you a 1% higher rate of interest. The amount you put in your FD is the same - only variable being the rate of interest.

I have not considered the tax component that may get cut from your interest component - but we shall delve into this at a later point.

How do I know how much rate of interest my bank offers?
Every bank puts up these figures on its website. I have copied the HDFC FD rate below as an example. These get updated regularly based on several macro factors, RBI guidelines etc.

Summary:

While compounding is a critical concept in wealth creation - it's important to also understand that - the rate of interest your bank offers you for your FD is important as well. Compounding starts to really show its magic after the first couple of years as your money grows - and the longer time frame you choose for your FD, the more savings you will amass.

Comments

Our Experience of Buying a House in 2021 in Dubai

Not the home we bought, but definitely a dream home. Source . We recently bought our first home, and we’ve written all about our experience, learnings and tips, and the whole process. However, after finishing the post, I realized it’s almost 2,500 words – so I wrote a shorter one – a summary, if you may – incase you just want to get a gist of it. But if you want to read in detail, scroll two paragraphs down. Summary: After calling several real estate agents and viewing a few apartments, we were told to start applying for the ‘pre-approval’ – as we would be buying the house on a mortgage. We contacted a mortgage consultant who supported us in our mortgage application. The pre-approval requires several documents and is one of the first steps to get started with the mortgage. The bank does an eligibility check on your credit limit, and in case you do not have enough credit, you will be asked to reduce your credit card limit. The pre-approval typically takes a week and is valid for 60 days

F.I.R.E - What Financial Independence & Retire Early Means

My mum loves sending me articles of how other 30-40 years old manage their finances. Recently, she shared with me an article that talked about how retired millionaires under 40 navigated the corona virus situation. But to be honest, I was not worried how they navigated the complete collapse in economies globally. I mean don't get me wrong, it is important - something I will cover in a later post. But I was more intrigued about the first part. How on earth were they able to retire as millionaires under 40!! Upon doing some online digging, I came to read about the concept of FIRE, again. I have heard this before. Have you? Or are you completely clueless - the way I was, the first time my colleague mentioned it to me? FIRE - as the title explains - refers to individuals that have gained financial independence and are now able to retire early - as they have reached the point where they don't have to work for money anymore. They can now do something they love, not having to sell awa

The Time vs Money Conundrum - How it Applies in Your Daily Life.

The time vs money conundrum. This does sound like a jargon, albiet an intuitive one. In its most basic form, it's a question; what is more important to you, time or money? You will hear honest answers and dishonest answers from all kinds of people. But have you ever wondered how it applies in your life? Not in a finance class test, not while discussing earnings potential with your fellow investment bankers during Thursday drinks, but in your day to day life? I used to earn 20,000 INR (≈ $250/month) 10 years ago. I was a happy go lucky person, rarely thought about saving, but thought very much about being seen using the latest fragrance from Bath & Body Works. I used to spend my entire salary on fragrances (think amazing smelling candles and lotions), rent, food and commute. This went on for 3 years. I saved zilch, save for some sad and unused candles. I studied engineering, and nobody had told me the importance of saving money. I now wish there was a basic finance class for eve

Cash22 - A personal finance blog

Search This Blog